Macro Prudential Policy: th d b t the debate and some d - - PowerPoint PPT Presentation

Macro‐Prudential Policy: th d b t d the debate and some implications for New Zealand implications for New Zealand

Prasanna Gai Prasanna Gai University of Auckland

NZ financial stability (IMF May 2011) NZ financial stability (IMF, May 2011)

Banks’ key vulnerabilities are their exposure to highly indebted – Banks’ key vulnerabilities are their exposure to highly indebted households and farmers together with their sizable short‐term offshore

• borrowing. Prudential measures and market pressures have led to a

reduction in banks’ sizable short‐term wholesale borrowing. g – New Zealand’s large net foreign liabilities expose it to a possible rise in long‐term interest rates as a result of high funding requirements of g f g f g q f banks and sovereigns in advanced economies. – The authorities should continue to strengthen their stress testing of g g f banks and consider the merits of gradually raising bank capital to levels well above the Basel III requirements. – Staff recommended explicitly including funding risk in future scenarios, encompassing a disruption to bank funding and a large increase in longer‐term interest rates. The latter could come from a rise in global rates and an increase in New Zealand banks’ risk premium rates and an increase in New Zealand banks risk premium.

NZ bank funding NZ bank funding

Roadmap Roadmap

Th t t f th d ti l li d b t

• The state of the macro‐prudential policy debate

S h ll i i

• Some challenging issues

– Do solutions like the CFR reduce financial instability? – How do financial shocks translate into real activity? – Do stress tests properly handle systemic externalities? – How do we attenuate risk illusion?

• Concluding observations

State of the debate (1): the meaning of macroprudential policy

• Commonly interpreted as system‐wide prudential

policy policy

• Care about the dynamic resilience of the financial

system

• Two aspects: procyclical (time series) and

resilience (cross‐sectional) ( )

• Traditional macro policy instruments may have a role
• Traditional macro‐policy instruments may have a role

to play

State of the debate (2): cycles in financial variables

• Key exemplar: The leverage‐margin‐liquidity cycle in

financial (and housing) markets

↑ optimism →↑asset prices and financial market liquidity→↓haircuts, margin requirements →↑leverage

• Why?

– Advent of market‐based intermediation – Prevalence of universal banking – Richer interlinkages between retail banks, i‐banks, broker‐ dealers dealers

State of the debate (3): system resilience

i i l di l h i i f

• Financial systems display characteristics of a

complex adaptive network

– robust‐yet‐fragile, pre‐disposed to tipping points – feedback behaviours that amplify initial shocks (li idit h di d t fi l ) (liquidity hoarding and asset firesales) – sensitive to diversity (risk management and search for yield) yield)

Si ifi t l h th b k

• Significant real consequences when they break

down

The basic externality (1) The basic externality (1)

• Individual agents do not take the spillover effects

Individual agents do not take the spillover effects – on system stability – of their financial actions into account, e.g.

– firesale externalities – liquidity hoarding(*) – location/size in the network – “local think” or ignorance of tail events – (over‐)borrowing

• Spillover effects on resource allocation are also

ignored ignored.

The basic externality (2) The basic externality (2)

l i i i i i i

• Solutions are Pigouvian in spirit – taxes or

constraints (static, state‐contingent, time‐ varying)

– systemic capital/liquidity surcharges – levy on non‐core deposits – changes to haircuts g – core funding ratios

• Quantities or prices?

CFR and dynamic resilience (1): probability of funding contagion

0.9 1 0.6 0.7 0.8 0.3 0.4 0.5 0.1 0.2 10 20 30 40 50 60 70 80 90 100

Frequency of systemic hoarding (Geometric baseline) Extent of systemic hoarding (Geometric baseline) Average degree (i.e. connectivity) Frequency of systemic hoarding (Geometric with Core Funding Ratio) Extent of systemic hoarding (Geometric with Core Funding Ratio)

CFR and dynamic resilience (2): time‐varying policy

1 0.8 0.9 1 0.5 0.6 0.7

systemic hoarding

0 2 0.3 0.4

Frequency of s

0.1 0.2 5 10 15 20 25 5 10 15 20 25

Initial aggregate haircut (h) Baseline Under Core Funding Ratio

Financial crises and real activity (1) Financial crises and real activity (1)

Ch i C i i bl f h 200 2009 i Changes in per Capita Variables for the 2007‐2009 Recession (percent) Output Consumption Investment Employment Hours United States ‐7.2 ‐5.4 ‐33.5 ‐6.7 ‐8.7 Canada ‐5.1 0.9 ‐15.3 ‐0.3 ‐4.8 New Zealand ‐5.3 ‐3.4 ‐20.9 ‐1.5 ‐5.9

Source: Ohanian (2010), Bank of Canada, RBNZ.

Financial crises and real activity (2) Financial crises and real activity (2)

400 Hours/quarter

Quarterly Hours worked per capita

Total hours worked as a ratio of the total working population 340 360 380 400 260 280 300 320 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 200 220 240 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Canada US New-Zealand Last observation: 2010Q4 Source: National Statistical Agencies

20% %

Household Credit Growth

year-over-year 15% 20% 5% 10% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

• 5%

0% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Canada US New-Zealand Last observation: 2010Q4 Source: National Central Banks

Stress testing (1) Stress‐testing (1)

S ll l d i

• Stress‐tests usually scale up adverse macroeconomic

shocks (e.g. unemployment=10%, commercial property declines=45%) declines=45%)

• But feedback effects mean that smaller shocks could
• But feedback effects mean that smaller shocks could

have major consequences

– network domino effects network domino effects – distress firesale of assets – macroeconomic feedbacks on default probabilities from macroeconomic feedbacks on default probabilities from the withdrawal of credit – funding risks

Stress‐testing (2): A hypothetical exercise

• Euro area stress test (2010) assumed a drop in the value of major

equity indices of 20% under the adverse scenario, which translated i t h i t f 36% f it [“fi l ”] into a haircut of 36% of equity exposures [“firesales”]

• Availability of credit to firms in the UK fell by 20% following

y y g Northern Rock [“macroeconomic feedbacks”]

• LGD on interbank exposures of 100% Capital buffers vary 4‐24%

LGD on interbank exposures of 100%. Capital buffers vary 4 24%

• Network calibrated on 17 UK banks in the core and 240 foreign

banks loans size and connections calibrated with BIS banking data banks, loans size and connections calibrated with BIS banking data. 50,000 firms, corporate PDs calibrated to Moodys data 1930‐2006.

• Question: how big would an initial macroeconomic shock need to

be to deliver calamitous results?

Stress testing (3) Stress‐testing (3)

Stress‐testing (4): adding funding liquidity risk

19

The problem of risk illusion (1) The problem of risk illusion (1)

• Improved beliefs about macroeconomic

prospects can give rise to risk illusion and p p g bring about “search for yield” like behaviour

• A serious policy problem: How to limit

tendencies to engage in “local think”/ “group think”? Can we encourage diversity in think ? Can we encourage diversity in business lines and risk management practices?

The problem of risk illusion (2) The problem of risk illusion (2)

0 0009 %

Shock to Slope of the Yield Curve

Response of Risk Illusion 0 0100 %

Shock to Risk Illusion

Response of Securitization/bank credit outstanding 0.0006 0.0007 0.0008 0.0009 0.0060 0.0080 0.0100 0.0003 0.0004 0.0005 0 0000 0.0020 0.0040 1 2 3 4 5 6 7 8 9 1011121314151617181920 0.0000 0.0001 0.0002 1 2 3 4 5 6 7 8 9 1011121314151617181920

• 0.0040
• 0.0020

0.0000 1 2 3 4 5 6 7 8 9 1011121314151617181920 95% confidence interval Source: Authors Calculations 1 2 3 4 5 6 7 8 9 1011121314151617181920 95% confidence interval Source: Authors Calculations

Concluding observations (1) Concluding observations (1)

Th l b k i k

• The central bank as risk manager

Vulnerabilities highlighted by the IMF are quite real. As the global outlook worsens, macroprudential measures will be key Swap‐covered funding has risks will be key. Swap covered funding has risks Banks do not internalise funding liquidity risks to a s do ot te a se u d g qu d ty s s to society as a whole. CFR a wise move and should be time‐varying. A complementary menu of instruments could also be developed and deployed could also be developed and deployed. “War games” and (dynamic) stress‐testing ought to be  War games and (dynamic) stress‐testing ought to be moved up the agenda

Concluding observations (2) Concluding observations (2)

P t i i l f th t fi i l t bilit

• Post‐crisis analyses of the monetary‐financial stability

nexus

Yet to capture critical systemic externalities Yet to articulate how economies fall to pieces after financial shocks – interactions between “wedges” not understood understood Yet to address shadow banking and broad credit creation Yet to tackle problems of risk illusion, “low for long”, and the search for yield the search for yield

Concluding observations (3) Concluding observations (3)

i i fi i l l i

• Open issues in financial regulation

 nature of banking – universal banks, ring‐fencing and the systemic consequences thereof y q  targeting systemically important FIs  targeting systemically important FIs  re wiring the financial network are central  re‐wiring the financial network – are central counterparties desirable?